OXLC - I Bought The Dip In OXLC Yield 17%

2023-08-06 11:30:00 ET

Summary

• “Buying the Dip” is a tactic that benefits investors seeking capital gains and also income investors.
• Share price drops represent opportunities for higher income, not a loss.
• We discuss the importance of rising cash flows using Oxford Lane Capital as an example.
• The projected rise in cash flow and growing distributions make Oxford Lane an excellent investment at these depressed prices.

Co-authored with PendragonY.

Buy the Dip, a tactic for all strategies

We see many articles encouraging investors to consider "Buying the Dip" – that's when the price of a stock drops more than the value declines due to market sentiment. Have you ever wondered why? Unlike many other tactics, buying a stock when the price drops is fit for most, if not all, strategies. If you are a capital gains investor, buying on the Dip often means lowering your cost basis and making it more likely that when you sell, the share price is higher than your cost. So it is easier to get a capital gain. Buying on a dip makes it easier to buy low and sell high. And it can also increase the difference between the buy and sell prices, making for a more significant gain.

For income investors like us, buying on the Dip means one of two things, your investment dollars buy you more income, or you need fewer investment dollars to buy the income you require.

Let's look at the math to see the benefits of buying the Dip for income investors. Let us assume there is a stock that trades at $10 and generates $1.20 in EPS. The stock has good revenue growth and pays $1 in dividends. If market action leads to a drop in the stock price to $9, and the company’s earnings, revenues, or dividends remain unimpacted, why would you sell it at $9?

• Even if you had purchased many shares at $10, would it not be better to buy more at $9?

• Wouldn't a yield of 11% sweeten the pot better than the 10% yield if nothing else but the share price had changed?

This is an opportunity. My 100 shares (purchased for $1,000) can only be sold for only $900. Yet that implies I can buy 100 shares for $900, getting the same $100 in annual income.

Long-term investors (and income investors) must understand the difference between unrealized and realized losses. Even the greatest investors have seen their holdings drop in value, but patience and persistence have played a key role in long-term success. And it is certainly nice to get paid in dividends to wait for the rebound.

The fear of losses can cost you far more than a temporary sentiment-driven drop in share price. When the shares you own experience price declines, there is a solid opportunity to increase your income.

My goal with investing is to grow my recurring income every month. When prices drop, I can grow my income faster. Let's take a look at a recent pick where I averaged down and bought the dip.

Revisiting Our Investment In OXLC

Oxford Lane Capital Corporation ( OXLC ) is a Closed-End Fund ("CEF") that invests in the "equity" tranche of collateralized loan obligations ("CLO"). CLOs are actively managed portfolios of senior secured loans to publicly rated companies. These loans are typically taken out by companies rated B/B+ by rating agencies, which includes many publicly traded companies.

OXLC recently hiked its distribution by 6.7%. However, because the CEF experienced both share price and the NAV decline over the past year, many found this to be shocking. Before the distribution hike, OXLC already offered a generous yield of over 17%. Such a yield is seen to be at a nose-bleed level, and investors tend to dismiss the security immediately as "high risk" just because of the yield.

Distributions are not paid in percentages; they are paid in cash. What matters most is if the fund can support the cash distribution with its earnings. Looking at the performance over recent quarters, it is clear that OXLC was not just able to maintain the distribution, but it was also able to increase it.

We don't hyperventilate over asset price drops because the prices don’t determine our dividend income; cash flows do. The outstanding loan amount and the number of defaults primarily drive cash flows for a CLO fund. The NAV for CLOs is calculated based on actual defaults and projections of future defaults. With defaults near historic lows, CLOs have much better cash flows than their NAV would suggest. Also, demand for CLOs has been relatively high, and CLO issuers have been able to get excellent prices on the debt tranches. This means they don't need to sell the equity tranches to make the CLO profitable. So the limited number of buyers for the equity tranches have been able to get great prices.

At HDO, we are income investors. We buy income streams by purchasing shares in companies and funds that pay well-supported dividends. We don't seek to profit from flipping our company to make a quick buck from some other trader. Our top priority is a safe and generous income stream our assets produce. What does share price tell us about the income an asset generates? Often quite less than other easily determined metrics.

This is why we have focused on the cash flow that OXLC produces. In May, the Q1 earnings report had a headline that wasn't the greatest – core Net Investment Income ("NII") declined to $0.22 for the quarter, short of the $0.225 distribution that OXLC paid and the market ran away.

We can see that while Core NII is never entirely flat, the decline over the prior quarter was significant. As Joe Kupka, managing director explained on the earnings call , CLOs borrow and lend at floating rates. The borrowers can use either a 3-month or 1-month floating rate, while the CLO borrows at a 3-month floating rate. In most quarters, the difference is minimal, but thanks to the uncertainty surrounding the Fed and its rapid increase in interest rates, the spread between 3-month and 1-month LIBOR was over 0.6% by the end of October. This had a significant impact on the January equity payment. By January, that spread reduced to 0.38%, and today it is down to 0.23%.

We were confident that this reduction in the spread should produce greater NII for the CLO funds. Sure enough, cash flow rebounded with strength in the 2nd quarter, with OXLC reporting Core NII of $0.43/share. More than covering the newly raised dividend. By recognizing this reality, we were able to buy the dip before quarterly earnings confirmed that NII was higher.

The bottom line is that the price variations don't mean much in the big picture. CLO equity returns are driven by default rates. And the cash flow to the equity tranches is determined in part by various ratios, including how many of the underlying loans are rated CCC or lower. This report shows that default rates and the percentage of loans rated CCC remain relatively low. OXLC is managing its CLOs to extend the reinvestment periods, and this should continue to provide solid cash flow to the CEF to support its distribution better.

So while others were selling off shares of OXLC following Q1 earnings, we continued to suggest it as a buy. The price is rallying, the dividend is higher and OXLC is now posting a respectable total return year-to-date.

Like most debt investments, OXLC's price is still well below 2022 highs, providing plenty of upside potential alongside its healthy double-digit dividend. It is still a very attractive price to buy today in the big picture.

Conclusion

Buying the Dip is a well-proven investment tactic as part of several strategies. Income investors need to look beyond price drops to ensure that the distribution is well-supported by the operations. Oxford Lane Capital Corporation is supporting a higher distribution through its growing cash flows.

A key to the Income Method is to develop a portfolio that is producing enough income that you are never forced to sell a stock to get the income you need. The goal is to develop a portfolio to produce enough income that you can meet your withdrawal needs, and still have some left over to reinvest in order to grow your income more. Since you are never forced to sell, you become a net buyer of stocks at all times. In other words, the only reason you would sell a stock is if you intended on investing that capital somewhere else into an investment you view as "better." You won't need to sell for the purpose of withdrawing your money and shrinking your portfolio. You will always be a buyer of stocks.

Who benefits from lower prices, the buyer or the seller? The buyer of course!

When the market panicked and sold off Oxford Lane Capital Corporation, I bought more shares on the dip and grew my income. Did you?

For further details see: